ratio analysis accounts

8/14/2019 Ratio Analysis Accounts

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Welcome to Ratio Analysis!

Financial ratio analysis is a fascinating topic to study because it can teach us so much about

accounts and businesses. When we use ratio analysis we can work out how profitable a business is,

we can tell if it has enough money to pay its bills and we can even tell whether its shareholders

should be happy!

Ratio analysis can also help us to check whether a business is doing better this year than it was last

year; and it can tell us if our business is doing better or worse than other businesses doing and

selling the same things.

In addition to ratio analysis being part of an accounting and business studies syllabus, it is a very

useful thing to know anyway!

The overall layout of this section is as follows: We will begin by asking the question, What do we

want ratio analysis to tell us? Then, what will we try to do with it? This is the most important

question, funnily enough! The answer to that question then means we need to make a list of all of

the ratios we might use: we will list them and give the formula for each of them.

Once we have discovered all of the ratios that we can use we need to know how to use them, who

might use them and what for and how will it help them to answer the question we asked at the

beginning?

At this stage we will have an overall picture of what ratio analysis is, who uses it and the ratios they

need to be able to use it. All that's left to do then is to use the ratios; and we will do that step- by-

step, one by one.

By the end of this section we will have used every ratio several times

and we will be experts at what do we want ratio analysis to tell us?

The key question in ratio analysis isn't only to get the right answer: for example, to be able to say

that a business's profit is 10% of turnover. We have to start working on ratio analysis with the

following question in our heads:

What are we trying to find out?

Isn't this just blether, won't the exam just ask me to tell them that profit is 10% of turnover? Well,

yes, but then they want to know that you are a good student who understands what it means to say

that profit is 10% of turnover.

We can use ratio analysis to try to tell us whether the business

1. is profitable

2. has enough money to pay its bills


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3. could be paying its employees higher wages

4. is paying its share of tax

5. is using its assets efficiently

6. has a gearing problem

7. is a candidate for being bought by another company or investor

and more, once we have decided what we want to know then we can decide which ratios we need to

use to answer the question or solve the problem facing us.

There are ratios that will help us with question 1, but that wouldn't help us with question 2; and

ratios that are good for question 5 but not for question 4 - we'll see!

Let's look at the ratios we can use to answer these questions.

The Ratios

We can simply make a list of the ratios we can use here but it's much better to put them into

different categories. If we look at the questions in the previous section, we can see that we talked

about profits, having enough cash, efficiently using assets - we can put our ratios into categories

that are designed exactly to help us to answer these questions. The categories we want to use,

section by section, are:

1. Profitability: has the business made a good profit compared to its turnover?

2. Return Ratios: compared to its assets and capital employed, has the business made a good

profit?

3. Liquidity: does the business have enough money to pay its bills?

4. Asset Usage or Activity: how has the business used its fixed and current assets?

5. Gearing: does the company have a lot of debt or is it financed mainly by shares?

6. Investor or Shareholder

Not everyone needs to use all of the ratios we can put in these categories so the table that we

present at the start of each section is in two columns: basic and additional.

The basic ratios are those that everyone should use in these categories whenever we are asked a

question about them. We can use the additional ratios when we have to analyse a business in more

detail or when we want to show someone that we have really thought carefully about a problem.

Users of Accounting Information

Now we know the kinds of questions we need to ask and we know the ratios available to us, we

need to know who might ask all of these questions! This is an important issue because the person

asking the question will normally need to know something particular.


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What are you going to do if someone asks you to tell them whether a business is profitable or not?

Firstly, do you remember what profit is? Profit is the difference between turnover, or sales, and

costs: that is,

profit = turnover - costs

One problem is that there are several ways of measuring profit: gross profit; net profit before and

after taxation; and retained profit are just some of them. So, you didn't print out those Tesco

accounts we showed you did you? Well, look back at them to remind yourself of all these names for

profit

A profit margin is one of the profit figures we just mentioned shown as a percentage of turnover.

They always tell us how much profit, on average, our business has earned per 1 of turnover.

We already know from the ratios table that there are several ratios we could use to calculate the

profitability of a business. Next we'll discuss gross and net profit margins.

Gross Profit Margin

First some basic profitability equations:

Gross Profit Margin =Gross Profit

Turnover* 100

Remember:

Turnover = Sales

Gross Profit = Turnover - Cost of Sales

The gross profit margin ratio tells us the profit a business makes on its cost of sales, or cost of

goods sold. It is a very simple idea and it tells us how much gross profit per 1 of turnover our

business is earning.

Gross profit is the profit we earn before we take off any administration costs, selling costs and so

on. So we should have a much higher gross profit margin than net profit margin.

Here are a few examples of the gross profit margins from different businesses:

Leisure

&

Hotels

International

Airline

Manufacturer Retailer Discount

Airline

Refining Pizza

Restaurants

Accounting

Software

Gross 9.64% 5.62% 35.14% 11.41% 27.46% 11.99% 47.52% 89.55%


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profit

See how the gross profit margins vary from business to business and from industry to industry. For

example, the international airline has a gross profit margin of only 5.62% yet the accounting

software business has a gross profit margin of 89.55%.

If a company's raw materials and factory wages go up a lot, the gross profit margin will go down

unless the business increases its selling prices at the same time.

Net Profit Margin

First some basic profitability equations:

Net Profit Margin =Net Profit

Turnover* 100 =

Profit before Interest and Taxation

Turnover* 100

Remember:

Net Profit = Gross Profit - Expenses

Why do we have two versions of this ratio - one for net profit and the other for profit before interest

and taxation? Well, in some cases, you will find they use the term net profit and in other cases,

especially published accounts, they use profit before interest and taxation. They both mean the

same: look back at the financial statements for Tesco where we compared different names for the

same things.

The net profit margin ratio tells us the amount of net profit per 1 of turnover a business hasearned. That is, after taking account of the cost of sales, the administration costs, the selling and

distributions costs and all other costs, the net profit is the profit that is left, out of which they will

pay interest, tax, dividends and so on.

Here are a few examples of the net profit margins from the same businesses we saw in the gross

profit margin section:

Leisure

&

Hotels

International

Airline


Airline

Refining Pizza

Restaurants

Accounting

Software

Net

Profit

7.36% 4.05% -10.48% 1.63% 10.87% 12.63% 7.55% 27.15%

Just like the gross profit margins, the net profit margins also vary from business to business and

from industry to industry. When we compare the gross and the net profit margins we can gain a

good impression of their non-production and non-direct costs such as administration, marketing and

finance costs.


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We saw that the international airline's gross profit margin was the lowest of this group of eight

businesses at only 5.62%; but look, its net profit margin is 4.05%, only a little bit lower than its

gross profit margin. On the other hand, the discount airline's gross profit margin is 27.46% but its

net profit margin is a lot less than that at 10.87%. As we just said, these comparisons give us a

great insight into the cost structure of these businesses.

Look at the software business too, a very high gross profit margin of 89.55% but a net profit margin

of 27.15%. This is still high, but we can now see that the administration and similar expenses are

very high whilst its cost of sales and operating costs are relatively very low.

Rate of Return

First some basic Rate of Return equations:

Return on Capital Employed (ROCE) =Profit for the Year

Equity Shareholders' Funds* 100

Return on Total Assets (ROTA) =PBIT

Total Assets* 100

The rate of return ratios are thought to be the most important ratios by some accountants and

analysts. One reason why the rate of return ratios are so important is that they are the ratios that

we use to tell if the managing director is doing their job properly.

Return on Capital Employed Ratio

The Return on Capital Employed ratio (ROCE) tells us how much profit we earn from the

investments the shareholders have made in their company. Think of it this way: if we had a savings

account with a bank and we'd been paid, say, 25 interest at the end of a year; and we had saved

500, we could work out the rate of interest we had earned:

Rate of interest =Interest earned

Amount saved* 100 =

25

500* 100 =

1

20* 100 =

100

20= 5%

So, we have earned 5% interest on our savings.

Imagine now that instead of talking about a savings account, we were talking about a company and

the profit for the year and its capital employed had been 25 and 500 respectively then the ROCE

for that company would be 5% too.

ROCE =Profit for the Year

Equity Shareholders' Funds* 100 =

25

500* 100 =

1

20* 100 =

100

20= 5%

Did you notice that we use the Equity Shareholders' Funds instead of Capital Employed? In fact,

they are different names for the same thing! We could call the ratio the Return on Shareholders'


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Funds (ROSF) just as easily if we wanted; but generations of accountants and students only know it

as ROCE.

In accounting, there can be different definitions of what certain terms mean. The use of the term

'capital employed' can mean different things. It can, for example, include bank loans and overdrafts

since these are funds employed within the firm. Because there are different interpretations of whatROCE can mean, it is suggested that you use a method which you feel comfortable with but be

aware that others may interpret your definition in a different way. Below is a guide to some of the

interpretations that we have found on this issue.

Source and/or Definition of Return Definition of Capital Employed

Elliott & Elliott: ROCE = Net profit/capital

employedCapital employed = total assets

Investor Words:Capital employed = fixed assets + current assets -

current liabilities

investopedia.com: Return = Profit before tax

+ interest paid

Capital employed = ordinary share capital + reserves

+ preference share capital + minority interest +

provisions + total borrowings - intangible assets

Holmes & Sugden: Return = trading profit

plus income from investment and company

share of the profit of associates

TRADING capital employed = share capital + reserves

+ all borrowings including lease obligations, overdraft,

minority interest, provisions, associates and

investments

OVERALL capital employed = share capital + reserves

+ all borrowings including lease obligations, overdraft,

minority interest, provisions

DTI

Capital employed = total fixed assets + current assets

- (current liabilities + long term liabilities +

provisions)

Johnson Matthey Annual Report & AccountsCapital employed = fixed assets + current assets -

(creditors + provisions)

Let's calculate the ROCE for the Carphone Warehouse now; and here are the figures we need:

Carphone Warehouse 31 March 2001 25 March 2000

'000 '000

Profit for the financial period 38,159 16,327

Equity shareholders' funds 436,758 44,190

Off you go!

Did you get this?
http://www.bized.ac.uk/compfact/ratios/ror3a.htmhttp://www.bized.ac.uk/compfact/ratios/ror3a.htm


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What do we think of these results? Well, the question we have to ask is

"Could we have earned more money (profit) if we had invested in a different business or simply put

our money in the bank?"

Well, interest rates at the bank were somewhere around 4 or 5% in 2001 so we did better thanthat; but there are many businesses that have a ROCE of higher than 8 or 9%. Still, in 2000 the

Carphone Warehouse had an ROCE of almost 37%: that's very good by all standards.

So what went wrong between 2000 and 2001? What happened, it didn't necessarily go wrong, was

that the capital employed increased from 44,190,000 to 436,758,000 (a 10 fold increase) BUT

the profits increased from 16,327 to only 38,159... they only just about doubled.

It's no surprise then that the ROCE fell so sharply as capital employed increased 5 times faster than

the profit did.

It will be interesting to see what 2002 brings for the Carphone Warehouse and their ROCE.

We will look at Vodafone's ROCE shortly, but for interest here are some other ROCE values to

compare with the Carphone Warehouse:

Leisure

&

Hotels

International

Airline


Airline

Refining Pizza

Restaurants

Accounting

Software

ROCE 5.56% 3.16% -12.12% -0.12% 33.63% 16.17% 16.14% 16.29%

Again, these other ROCE values demonstrate that not everyone can get the same results for the

same ratio at the same time: it depends on the industry, the management, the economy and so on.

The ROCE results in this new table relate to the Carphone Warehouse's results for the year ended

25 March 2000 of 36.95%. This is a good result as it shows that the business is effectively earning

around 37% on the (investment) funds that the shareholders have invested in it.

Contrast the other ROCE values with the Carphone Warehouse and we can see that only the

discount airline has a ROCE value anywhere near it. The international airline's ROCE is extremely

low at just over 3%. Wouldn't the shareholders be better off selling the business and putting the

money in the bank as it would earn more than that?

We should also compare these ROCE values with the profitability values. Let's just compare net

profitability with the ROCE.

Leisure

&

International

Airline


Airline

Refining Pizza

Restaurants

Accounting

Software


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Hotels

Net

Profit

7.36% 4.05% -10.48% 1.63% 10.87% 12.63% 7.55% 27.15%

ROCE 5.56% 3.16% -12.12% -0.12% 33.63% 16.17% 16.14% 16.29%

Putting the data from this table on a graph can help us to see if there is a relationship between

them:

There does seem to be a relationship between the net profit margin and the ROCE: the higher the

net profit margin, the higher the ROCE. After all, the curve on this graph is not a straight line and it

might even be a true curve meaning that the relationship is more complex than we might think.

Keep an eye on this relationship whenever you assess the profitability of a business.

Liquidity ratios

Current Assets: Current Liabilities

(Current Assets-Stocks): Current Liabilities

The two liquidity ratios, the current ratio and the acid test ratio, are the most important ratios in

almost the whole of ratio analysis are also the simplest to use and to learn

The Current Ratio

The current ratio is also known as the working capital ratio and is normally presented as a real

ratio. That is, the working capital ratio looks like this:


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Current Assets: Current Liabilities = x: y eg 1.75: 1

The Carphone Warehouse is our business of choice, so here is the information to help us work out

its current ratio.

Consolidated Balance Sheet 31 March 2001 25 March 2000

'000 '000

Total Current Assets 315,528 171,160

Creditors: Amounts falling due within one year 222,348 173,820

As we saw in the brief review of accounts section with Tesco's financial statements, the phrase

current liabilities is the same as Creditors: Amounts falling due within one year.

Here's the table to fill in. OK, so we've done this one for you!

Current Ratio For the Carphone Warehouse

31 March 2001 Current Assets: Current Liabilities 315,528: 222,348 1.42: 1

25 March 2000 Current Assets: Current Liabilities 171,160: 173,820 0.98: 1

Maths revision. How did we get 1.42: 1 for the year ended 31 March 2001? All we did was to divide

the current assets by the current liabilities and that gives us:

current assets

current liabilities=

315,528

222,348= 1.42

so we automatically know that our ratio is 1.42: 1

The same with the year before:

current assets

current liabilities=

171,160

173,820= 0.98

so the ratio is 0.98: 1

Asset Usage

The assessment of asset usage is important as it helps us to understand the overall level of

efficiency at which a business is performing.

The basic equations for this section are:

Total Asset Turnover =Turnover

Total Assets


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Stock Turnover =Average Stocks

Credit Sales/365

Debtors' Turnover =Average Debtors

Credit Sales/365

Creditors' Turnover =Average Creditors

Credit Sales/365

The assessment of asset usage is important as it helps us to understand the overall level of

efficiency at which a business is performing.

Our basic ratios for this section are

Total asset turnover - The overall efficiency of the business. We will look at total asset turnover

and net asset turnover; then we will investigate the fixed and current asset turnover ratios.

Stock turnover, Debtors' turnover and Creditors' turnover help us to assess the liquidity

position as well as giving us detailed information about stock control and credit control.

We'll look at total asset turnover first and then we'll look at the other three together, under the

general heading of working capital management II

Working Capital Management II

What we are about to study - stock, debtors and creditors control - are all part of working capital

management in the same way that a discussion of liquidity was part of working capital

management.

We know that working capital is concerned with the ability of a business to be able to pay its way.

The three ratios we are concerned with now are concerned with spending and saving money in the

right places. Too much stock and we waste money on buying it and keeping it. Too much money

loaned to our debtors and it's money we can't use for something else, such as buying machinery,

paying our creditors or even investing it. Too much money in the form of creditors and we might

have a problem that no one else will give us credit for anything else because they think we can't

afford it, and, if we suddenly have a cash problem, we might not be able to pay our creditors.

Working capital management is concerned with the control aspects of the issues we have just

mentioned.

Stock Turnover: stock control


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In principle, the lower the investment in stocks the better. Apart from buffer stocks that businesses

sometimes need in case of shortages of supply and strategic stocks in case of war, sudden changes

in demand and so on, modern stock control theory tells us to minimise our investment in stocks.

Let's see how the Carphone Warehouse behaves in this respect.

The formula for this ratio is:

Stock Turnover =Average Stocks

(Cost of Sales/365)

Carphone Warehouse

Consolidated Profit and Loss Account

31 March 2001 25 March 2000

'000 '000

Cost of sales 830,126 505,738

Stock 52,437 51,842

Stock Turnover Ratio for the Carphone Warehouse

31 March 2001 52,437

830,126 / 365

23.06 days

25 March 2000 51,842

505,738 / 365

37.42 days

If you use alternative formulae and are happy with them, that's fine. If you think you

need help because of that, see your teacher/lecturer for guidance.

Firstly, the result of this calculation is that the answer is instantly in terms of the number of

days, on average, that the stocks are held in the business.

Secondly, we use the cost of sales figure because stocks are bought and shown in the profit

and loss account and the balance sheet at cost; so we need to compare like with like.

Thirdly, we only have two years' worth of stock information, so we can't use the average stock

for both years as we should do according to the formula. Never mind, even though the answer

won't be 100% spot on, it will give us a very good estimate of how stock control is going.

How can we interpret this ratio? With a result of 23.06 days, we can imagine that we bought our

52,437,000 worth stocks of raw materials or whatever they were on 1st January 2002. We then

know that we ran out of those raw materials on 1 + 23.06 days = just into 25th January.

Similarly with the result of 37.42 days, if we bought our 51,738,000 worth of raw materials on 1st

January, we would run out and have to buy some more on 7th February.


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This ratio has fallen from 37 days to 23 days over the two years and that is probably a good thing.

If there's less stock to worry about, lower investment in stocks meaning that the money they used

to have tied up in the stock room is now free to spend somewhere else.

In fact, stocks have remained at around 52 million as we mentioned before, but the cost of sales

has increased by 64% over the two years. Put these two facts together and that explains theimprovement in this ratio.

Well done the Carphone Warehouse!

Remember that we talked about the liquidity of stocks when we discussed the acid test ratio. Now

we can see that the Carphone Warehouse's stocks are fairly liquid, since a turnover ratio of 23 days

isn't too bad!

Debtors' Turnover

In the same way that stock control is a vital aspect of working capital management, so too is

debtors' control. Many businesses need to sell their goods on credit, otherwise they might find it

difficult to survive if their competitors provide such credit facilities; this could mean losing

customers to the opposition.

Nevertheless, since we do provide credit, we must do so as optimally as possible. We've used the

word 'optimal' before and let me confirm that it doesn't necessarily mean the best possible, but the

best possible under the circumstances.

Why is credit control so important? For the Carphone Warehouse, the total amount owing by debtors

was 149 million at the end of 31 March 2001, which as a percentage of total assets, is 14.09%.That's a lot of money in absolute terms and relatively, and it's 80% more than it was the year

before.

So, they've given an additional 69 million worth of credit to their customers over the year. What we

need to know, though, is whether they are controlling these debtors. We can do that by looking at

their debtors' turnover ratios for the two years, firstly.

Carphone Warehouse 31 Mar 2001 25 Mar 2000

000 000

Turnover 1,110,678 697,720

Debtors due within one year 149,200 82,826

The formula for debtors' turnover is:

Debtors' Turnover =Average Debtors

Credit Sales/365


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We have to assume, by the way, that all sales are credit sales unless we know which sales are for

cash.

The calculations:

Debtors Turnover Ratio for the Carphone Warehouse

31 March 2002 149,200

1,110,678 365

49.03 days

25 March 2001 82,826

697,720 365

43.33 days

Well, what do you think of that?

Firstly, the ratio seems to have worsened by going from 43 to 49 days over the two years; and it

means that, on average, the Carphone Warehouse's debtors are taking one and a half months to

pay their accounts. Does this sound as if it's a good policy? How do we know?

One of the ways we can tell, in fact, whether this ratio is good or not is to go to a Carphone

Warehouse shop or go to their Web site and find out their terms of business. If we sign up with

them, will they give us around 49 days to pay our bills?

At the time of writing, the page http://www.carphonewarehouse.com/commerce/servlet/gben-

store-Mobile shows that there are a number of ways we can choose to get a phone from the

Carphone Warehouse:

Pay monthly

Handset only

Pay for calls ... no line rental

Pay as you go

Try and work out how it's possible to have a debtors' turnover figure of 49 days from these deals ...

it's not! So what's the problem? Well, do they have corporate customers who are allowed to pay

after, say, 55 days or 60 days? Do some research and find the answer if you can.

Creditors' Turnover Ratio

Creditors are the businesses or people who provide goods and services in credit terms. That is, they

allow us time to pay rather than paying in cash.
http://www.carphonewarehouse.com/commerce/servlet/gben-store-Mobilehttp://www.carphonewarehouse.com/commerce/servlet/gben-store-Mobilehttp://www.carphonewarehouse.com/commerce/servlet/gben-store-Mobilehttp://www.carphonewarehouse.com/commerce/servlet/gben-store-Mobile


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There are good reasons why we allow people to pay on credit even though literally it doesn't make

sense! If we allow people time to pay their bills, they are more likely to buy from your business than

from another business that doesn't give credit. The length of credit period allowed is also a factor

that can help a potential customer decide whether to buy from your business or not: the longer the

better, of course.

In spite of what we have just said, creditors will need to optimise their credit control policies in

exactly the same way that we did when we were assessing our debtors' turnover ratio - after all, if

you are my debtor I am your creditor!

We give credit but we need to control how much we give, how often and for how long. Let's do

some calculations for the Carphone Warehouse.


Creditors' Turnover =Average Creditors

(Cost of Sales/365)

As with the stock turnover ratio, creditor values relate to the costs of raw materials, goods and

services, which is why we use the cost of sales figure in the denominator (Remember the

numerator? Well, this is the opposite. The denominator is the bottom part of a fraction!)


'000 '000

Cost of sales 830,126 505,738

Creditors: Amounts falling due within one year 222,348 173,820

Creditors Turnover Ratio for the Carphone Warehouse

31 March 2001 222,348

830,126 365

97.76 days

25 March 2000 173,820

505,738 365

125.45 days

We interpret this ratio in exactly the same way as the debtors' turnover ratio. That is, in 2001 if we

had bought some supplies for 222,348 on 1st January, we would have paid for them 97.76 dayslater on 6th April. You can work out the payment date for 2000 if we imagine buying some supplies

for 173,820 on 1st January of that year.

Having found that debtors are taking somewhere between 30 and 50 days to pay their accounts,

notice that the business is taking over three months credit for itself in 2001 and about four months'

credit in 2000. These results are worrying: especially when we know that small businesses in the UK


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are suffering because large businesses take too long to pay their accounts; and if the Carphone

Warehouse has many small suppliers that is worrying.

You can now attempt an additional question.

Additional notes are available onadvanced stock, creditors and debtors or you can move on to theGearingsection.

Gearing 1

Gearing =Long Term Liabilities

Equity Shareholders' Funds

Gearing is concerned with the relationship between the long terms liabilities that a business has and

its capital employed. The idea is that this relationship ought to be in balance, with the shareholders'

funds being significantly larger than the long term liabilities.

Gearing 1

Shareholders ought to have the upper hand because if they don't that could cause them problems

as follows:

Shares earn dividends but in poor years dividends may be zero: that is, businesses don't

always need to pay any!

Long term liabilities are usually in the form of loans and they have to be paid interest; even in

bad years the interest has to be paid

Equity shareholders have the voting rights at general meetings and can made significant

decisions

Long term liability holders don't have any voting rights at general meetings but they have the

power to override the wishes of the shareholders if there are severe problems over their

interest or capital repayments

So, shareholders like to see the gearing ratio, the relationship between long term liabilities and

capital employed, being in their favour! Let's look at the Carphone Warehouse's gearing ratio.

The formula:

Gearing =Long Term Liabilities

Equity Shareholders' Funds

The data:
http://www.bized.ac.uk/compfact/ratios/sdc8_15.htmhttp://www.bized.ac.uk/compfact/ratios/sdc9.htmhttp://www.bized.ac.uk/compfact/ratios/sdc9.htmhttp://www.bized.ac.uk/compfact/ratios/gearing1.htmhttp://www.bized.ac.uk/compfact/ratios/gearing1.htmhttp://www.bized.ac.uk/compfact/ratios/sdc8_15.htmhttp://www.bized.ac.uk/compfact/ratios/sdc9.htmhttp://www.bized.ac.uk/compfact/ratios/gearing1.htm


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'000 '000

Creditors: Amounts falling due after more than one year 14,107 21,033

Equity shareholders' funds 436,758 44,190

Gearing Ratio for the Carphone Warehouse

31 March 2001 14,107: 436,758 0.032: 1

25 March 2000 21,033: 44,190 0.476: 1

A shareholder of the Carphone Warehouse will be happy with these results. Even in 2000 when the

ratio was relatively high at 0.476 or 47.6% they probably were not too worried because their other

ratios were fine too.

In 2001 the gearing ratio fell to almost zero indicating that the business much prefers equity

funding to debt funding. This minimises the interest payment problems and the control problems of

having a dangerously high level of long-term debt on the balance sheet.

Gearing 2

There is an alternative gearing ratio, we can call it the Gearing Ratio II.


Gearing 2 =

Long Term Liabilities

Long Term Liabilities + Equity Shareholders' Funds

Let's just get on with this one. Gather the necessary data from both of our businesses, Carphone

Warehouseand Vodafone and calculate this ratio for them.

The calculations:

Gearing II Ratio for the Carphone Warehouse

31 March 2001 14,107: 436,758 + 14,107 0.031: 1

25 March 2000 21,033: 44,190 + 21,033 0.322: 1

Gearing II Ratio for Vodafone

31 March 2002 13,118: 130,573 + 13,118 0.091: 1

31 March 2001 11,235: 145,007 + 11,235 0.072: 1
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Earnings per share: EPS

This is, perhaps, the fundamental investor ratio: in this case, we work out the average amount of

profits earned per ordinary share issued. The formula is:

Earnings per share = Profit available to equity shareholdersAverage number of issued equity shares

Here are the extracts from the accounts that we need and they are followed by the results for one

of the two years, you should calculate the EPS for the other year.

The Carphone Warehouse


31 March 2001 25 March 2000

Profit for the financial period () 38,159,000 16,327,000

Weighted average number of issued shares 833,000,000 600,000,000

31 March 2001 25 March 2000

EPS 38,159,000

833,000,000

0.04648 _____________

Did you get this?

The good news for investors here is that the average earnings per issued ordinary share has almost

doubled over the two years. Notice that the number of shares issued has increased from 600 million

to 833 million, so this really is a good result as profits available for shareholders must have

increased significantly too from 16,327,000 to 38,159,000.

Dividends per Share: DPS

The DPS ratio is very similar to the EPS: EPS shows what shareholders earned by way of profit for a

period whereas DPS shows how much the shareholders were actually paid by way of dividends. The

DPS formula is:

Dividends per share =Dividends paid to equity shareholders

Average number of issued equity shares

Oops, there are no dividend data for the Carphone Warehouse, on page 13 of their annual report

and accounts they say:

Profit for the period attributable to shareholders was 38.2m resulting intotal shareholders' funds of 436.8m at the period end. As in previous periods
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the Board has decided to retain these earnings for continued investment inthe development of the Group and the future enhancement of shareholdervalue and is not therefore proposing a dividend for the period.

Vodafone has paid dividends in recent years so gather the relevant data from the database and

calculate the DPS for it. Here are the templates we so kindly began to provide under the EPS

heading!

Here are two templates to help you along: aren't we kind?

Vodafone


31 Mar 2002 31 Mar 2001

Equity dividends ()

Weighted average number of issued shares

31 Mar 2002 31 Mar 2001

DPS

__________ ______ __________ ______

Did you get this?

Vodafone themselves report the DPS as

Dividend per share 1.4721p in 2002 and 1.4020p in 2001

In conclusion we can see that even though Vodafone is suffering large losses, it is still paying

dividends to its shareholders, yet the Carphone Warehouse, which is apparently in a better position

is not paying dividends.

Dividend Yield

The dividend yield ratio allows investors to compare the latest dividend they received with the

current market value of the share as an indictor of the return they are earning on their shares.

Note, though, that the current market share price may bear little resemblance to the price that an

investor paid for their shares. Take a look at the history of a business's share price over the last

year or two and you will see that today's share price might be a lot higher or a lot lower than it wasa year ago, two years ago and so on.

We clearly need the latest share price for this ratio and we can get that from newspapers such as

the Financial Times, The Times, The Guardian and the Daily Telegraph. We can also find the share

prices on the Internet.

The formula for the dividend yield is:
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Dividend yield =Latest annual dividends

Current market share price

It is common for newspapers and others to calculate the dividend yield automatically as part of their

offerings. Take a look at the extract from The Times and you'll find the dividend yield figure in the

second right hand column, before the P/E ratio.

Here's an extract from The Times newspaper's share page (Source: The Times Newspaper 18

September 2002) together with a few links to some Web sites where we can find share prices. Use

them now or later.

Dividend Cover

The dividend cover ratio tells us how easily a business can pay its dividend from profits. A high

dividend cover means that the company can easily afford to pay the dividend and a low value

means that the business might have difficulty paying a dividend. Here's the formula followed by an

example.

Dividend cover =Net profit available to equity shareholders

Dividends paid to equity shareholders

Since the Carphone Warehouse hasn't paid a dividend, let's turn to Vodafone immediately. In the

database find the data you need to calculate the dividend coverage for the two years for which we

have data for Vodafone and calculate the dividend cover ratio for those two years. Here's a template

for you to fill in with the data you find.

Vodafone

Consolidated profit and loss account

31 Mar 2002 31 Mar 2001

m m

Profit for the financial period

Dividends

Vodafone dividend cover 31 Mar 2002 31 Mar 2001

Profit for the financial period

Dividends

Did you get this?

In this case, we see a terrible situation, as usual, for Vodafone. The profit for the period is in fact

negative, so these results are dreadful - even though the values are positive, that is only because of

the mathematics ... Vodafone has no dividend cover at all for these two years
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Price Earnings Ratio: P/E ratio

The P/E ratio is a vital ratio for investors. Basically, it gives us an indication of the confidence that

investors have in the future prosperity of the business. A P/E ratio of 1 shows very little confidence

in that business whereas a P/E ratio of 20 expresses a great deal of optimism about the future of a

business.

Here's the formula, then we'll work through an example

Price/earnings or p/e ratio =Current market share price

Earnings per share

Here are the P/E ratios of five businesses in the Telecommunications sector:

Telecommunications P/E ratio

BT 48.4

Project Telecom 12.0

Telecom Plus 19.7

Vanco 78.4

Vodafone 17.9

Average 35.28

Source: The Times Newspaper 18 September 2002

See how big some of these P/E ratios are - that's not necessarily a good thing! Let's look at the

calculations and then we can interpret our findings.

Again, we need current market share prices as well as the EPS values. This means we can go back

to the Carphone Warehouse even though it isn't paying dividends at the moment:

The Carphone Warehouse pence P/E ratio

Current market share price 76.0

EPS 4.616.52

Note:

1. the current market share price is taken from The Times newspaper 18 September 2002 and

the EPS is taken from the table below (previously calculated in the EPS section, above)

2. we have worked in pence here; but we could just as easily have worked in Pounds and the

answer would have been the same, at a P/E ratio of 16.52


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The Carphone Warehouse

31 March 2001

EPS 38,159,000

833,000,0000.046

What does a P/E ratio of 16.52 mean? In raw terms it means that investors are currently paying the

equivalent of 16.52 years' worth of earnings to own a share in the Carphone Warehouse. That is,

they hare currently paying 76 pence per share and since the EPS is 4.6 pence per share, this means

that they will recover their investment in a share after 16.52 years - equivalent to the break even

and payback period if you like.

16.52 is a high value for a P/E ratio; but not the highest and essentially the higher the ratio the

better. However, we would say that P/E ratios of 78.4 and 48.4 are excessive and might reflect an

unreal situation. It's possible in extreme circumstances that the share price is, in fact, independent

of the current market share price so that a high P/E ratio is actually based on more up to date news

than last years EPS value.

BT has a P/E ratio of 48.4 yet it is not too long ago that it was heading for potential liquidation as its

victory in securing its third generation licences had led to its taking on a massive debt burden that it

could not, in reality, sustain. However, it seems now that investors like the current performance of

BT and are voting for it by buying its shares at highly inflated values relative to its EPS.

Ratio

From Wikipedia, the free encyclopedia

(Redirected from Ratio analysis)Jump to: navigation, search

For the use ofratio as a human capacity, see reason.

A ratio is a dimensionless, or unitless,quantity denoting an amount or magnitude of one quantity

relative to another.

Throughout the physical sciences, ratios of physical quantities are treated as real numbers. For

example, the ratio of 2rmetres to 1 metre is the real number 2r. That is 2rm/1m = 2r.

Accordingly, the classical definition ofmeasurement is the estimation of a ratio between a quantity

and a unit of the same kind of quantity.

The term ratio is also used to denote one proportion of a whole relative to the other proportion.

With such usage, the ratio is usually written as two numbers separated by a colon (:) which is read

as the word "to". A ratio of 2:3 ("two to three") means that the whole is made up of 2 parts of one

thing and 3 parts of another thus, the whole contains five parts in all. To be specific, if a basket
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More colloquially, a ratio is a value calculated by dividing one number by another. Five divided by

two gives a ratio of 2.5. In the business world it is typical to use ratios to analyze financial

statements. For example, the current ratio assesses liquidity, or time required for some asset to be

converted to cash. The current ratio looks at current assetsrelative to current liabilities.

One indicator, or ratio, for strength or stability ofrevenue in government is own source revenues(property taxes, for example) divided by total revenues (property tax and outside grants). In some

respects, a high ratio suggests safety and stability. Grants or intergovernmental revenues can be

taken away and heavy reliance on these outside sources, which would produce a low ratio, can spell

trouble for a state or local government.

Ratio Analysis Equations for Accountants

This page contains graphics images of the main and basic ratio analysis equations or formulae that

accountants and analysts use for ratio analysis. Feel free to download them for your own use by

cutting and pasting from here ... don't forget where you got them from!

New Ratio Analysis Equations

Profitability

Gross Profit Margin

Operating Profit Margin

Net Profit Margin

Retained Profit Margin

Profit Mark up
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Asset Usage

Total Asset Turnover

Stock turnover

Debtors Turnover

Creditors Turnover

Fixed Asset Turnover

Capital Employed

Turnover

Working CapitalTurnover

NOTE in the US stock = inventory, debtors = accountsreceivable, creditors = accounts payable

Alternative formulae:

Stock Turnover


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Debtors Turnover

Gearing

Gearing 1

Gearing 2

NOTE: in the US known as leverage

Investor

Earnings per Share

Dividends per Share

Dividend Yield

Dividend Cover

P/E (Price Earnings)


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Interest Cover

ratio analysis accounts

Documents